[In 1972, American
Express purchased almost 2 million shares of stock in Donaldson, Lufkin
& Jenrette, Inc. (DLJ), for $29.9 million. By 1975, the stock had declined
in value to approximately $4 million. American Express announced that it
would distribute the DLJ stock as a dividend. Two shareholders sued to
enjoin distribution of the dividend. They argued that American Express
would be better off selling the DLJ stock.

The shareholders pointed
out that a distribution of the DLJ stock would not have any impact on American
Express’s liability for income taxes. On the other hand, if American Express
sold the DLJ stock, it could reduce otherwise taxable capital gains by
an amount equal to its roughly $26 million loss on the DLJ stock and thus
save approximately $8 million in taxes. In effect, the shareholders’ argument
was that rather than distribute $4 million in DLJ stock as a dividend,
American Express could sell the stock, save $8 million in taxes, and then
(if it wished) distribute $12 million (the sale price plus the tax savings)
as a dividend.

The American Express
board of directors considered the shareholders’ argument at a meeting on
October 17, 1975, and decided to proceed with the dividend. The board had
previously been advised by its accountants that if the DLJ stock was distributed
as a dividend, rather than sold, American Express would not have to reduce
its reported income for 1975 to reflect its loss on its investment. Rather,
it could bypass its income statement and simply reduce retained earnings
by $29.9 million—the book value of the stock it would be distributing.]

Edward J. Greenfield,
Justice.

Examination of the
complaint reveals that there is no claim of fraud or self-dealing, and
no contention that there was any bad faith or oppressive conduct. The law
is quite clear as to what is necessary to ground a claim for actionable
wrongdoing. * * *

More specifically,
the question of whether or not a dividend is to be declared or a distribution
of some kind should be made is exclusively a matter of business judgment
for the Board of Directors.

* * * Courts will not
interfere with such discretion unless it be first made to appear that the
directors have acted or are about to act in bad faith and for a dishonest
purpose. It is for the directors to say, acting in good faith of course,
when and to what extent dividends shall be declared * * * The statute confers
upon the directors this power, and the minority stockholders are not in
a position to question this right, so long as the directors are acting
in good faith * * *.

Thus, a complaint must
be dismissed if all that is presented is a decision to pay dividends rather
than pursuing some other course of conduct. * * * The directors’ room rather
than the courtroom is the appropriate forum for thrashing out purely business
questions which will have an impact on profits, market prices, competitive
situations, or tax advantages. * * *

* * * The affidavits
of the defendants and the exhibits annexed thereto demonstrate that the
objections raised by the plaintiffs to the proposed dividend action were
carefully considered and unanimously rejected by the Board at a special
meeting called precisely for that purpose at the plaintiffs’ request. The
minutes of the special meeting indicate that the defendants were fully
aware that a sale rather than a distribution of the DLJ shares might result
in the realization of a substantial income tax saving. Nevertheless, they
concluded that there were countervailing considerations primarily with
respect to the adverse effect such a sale, realizing a loss of $25 million,
would have on the net income figures in the American Express financial
statement. Such a reduction of net income would have a serious effect on
the market value of the publicly traded American Express stock. This was
not a situation in which the defendant directors totally overlooked facts
called to their attention. They gave them consideration, and attempted
to view the total picture in arriving at their decision. While plaintiffs
contend that according to their accounting consultants the loss on the
DLJ stock would still have to be charged against current earnings even
if the stock were distributed, the defendants’ accounting experts assert
that the loss would be a charge against earnings only in the event of a
sale, whereas in the event of distribution of the stock as a dividend,
the proper accounting treatment would be to charge the loss only against
surplus. While the chief accountant for the SEC raised some question as
to the appropriate accounting treatment of this transaction, there was
no basis for any action to be taken by the SEC with respect to the American
Express financial statement.

The only hint of self-interest
which is raised, not in the complaint but in the papers on the motion,
is that four of the twenty directors were officers and employees of American
Express and members of its Executive Incentive Compensation Plan. Hence,
it is suggested, by virtue of the action taken earnings may have been overstated
and their compensation affected thereby. Such a claim is highly speculative
and standing alone can hardly be regarded as sufficient to support an inference
of self-dealing. There is no claim or showing that the four company directors
dominated and controlled the sixteen outside members of the Board. * *
*

Note: Accounting
Versus Economic Results

To assess the merits
of the American Express board’s decision to distribute the DLJ stock as
a dividend requires consideration of two questions. First, was the
board correct in its belief that stock market investors are more interested
in the accounting treatment of American Express’s divestiture of its interest
in DLJ than in that transaction’s financial impact on American Express?
Second, even if the board’s assessment was correct, should the court have
allowed the board to seek to increase the market price of American Express
stock by abjuring a transaction (selling the DLJ stock and recording the
loss) that would have produced a real economic benefit worth $8 million
to the company?

Professor Henry Hu
argues that managers’ fiduciary duty should be reformulated to require
maximization of the “intrinsic value” (i.e., the discounted cash flow value)
of a corporations’ stock, and that managers should disregard “evidence
that stock market pricing of shares is, to a disturbing extent, ill-informed
and irrational.” Henry T.C. Hu, Risk, Time and Fiduciary Principles in
Corporate Investment, 38 U.C.L.A. L.Rev. 277, 281 (1990).

As evidence that allowing
managers to focus on accounting results, rather than economic realities,
may produce economic costs far greater than those involved in Kamin, consider
that the risk management manual of Enron Corporation, which for years used
“aggressive” accounting to create the appearance of increasing profitability,
provided the following guidance:

Reported
earnings follow the rules and principles of accounting. The results do
not always create measures consistent with underlying economics. However,
corporate management’s performance is generally measured by accounting
income, not underlying economics. Risk management strategies are therefore
directed at accounting rather than economic performance.

As Kamin illustrates,
courts exhibit a strong propensity to extend the protection of the business
judgment rule to dividend decisions by the boards of public corporations.
As the court pithily observes, the prevailing rule is that the appropriate
battleground for such decisions is the boardroom, not the courtroom.

Decisions on whether
to distribute funds to shareholders are closely related to decisions concerning
investment and capital structure. Professors Merton Miller and Franco Modigliani,
two Nobel laureates, have pointed out that in a perfect capital market,
it makes no difference whether a corporation finances its investments internally
or distributes all the cash it lawfully can and then finances its investments
by borrowing the funds it needs or selling new equity. The choices a firm
makes should not affect either the value of the firm or the value of its
shareholders’ interests.

Nonetheless, boards’
decisions concerning what distributions to make and how to finance new
investments generally are viewed as important. In large part, that is not
because people reject the Miller-Modigliani insight but because the markets
in which corporations operate are far from perfect. At least three real
world factors make financing choices important: taxes; differences in the
information available to those who run the firm and those being asked to
invest in it; and the possibility those who run the firm make financing
decisions designed to promote their own interests rather than the interests
of the firm or those who have invested in it.

These factors have
led financial economists to develop three theories directed at explaining
corporations’ financing choices: a tradeoff theory, which focuses on the
impact of taxes; a pecking order theory, which focuses on information differences;
and agency cost theory, which focuses on self dealing. Research on corporations’
financing choices suggests that all of these theories have some merit,
but that none provides a complete explanation. As one recent survey points
out, “Debt ratios [and distribution practices] of established U.S. public
corporations vary within apparently homogenous industries. There is also
variation over time, even when taxation, information differences and agency
problems are apparently constant.” Stewart C. Myers, Corporate Structure,
15 J. Econ. Perspectives 81, 82 (2001).

The tradeoff theory
builds on the current tax code’s different treatment of interest and dividends,
described above in connection with our discussion of leverage. Because
interest is tax deductible and dividends are not, it might seem that every
firm will try to borrow to finance virtually all of the investments it
plans to make. However, as the risk of default increases, so does the interest
demanded by prospective lenders. Moreover, default or prospective default
generates additional costs for a borrower firm. Consequently, the tradeoff
theory suggests only moderate debt to equity ratios. More specifically,
it suggests that firms will borrow up to the point at which the marginal
value of the tax benefits from additional debt will be offset by the increased
possibility that incurring additional debt will lead to financial distress.
This suggestion comports with common sense. It also is consistent with
studies finding that companies with relatively safe, tangible assets tend
to have higher debt-equity ratios than firms with risky, intangible assets.
But other studies find that the most profitable firms in many industries—i.e.,
the firms best situated to take on additional debt—often borrow the least.
Thus, while the tradeoff theory has considerable explanatory power, some
other theory must explain at least some firms’ financing choices. See id.
at 88-91.

The pecking order theory
assumes that managers know the true value of a corporation’s existing assets
and investment opportunities but that investors do not. It further assumes
that managers, acting in the interest of existing shareholders, will not
issue new equity at a price below the present value of the firm’s existing
assets and investment opportunities and that investors, aware of this tendency,
therefore will assume that any new equity offering is overpriced and will
further mark-down the price they are prepared to pay. This makes it attractive
to managers to finance new investments internally if they can, because
internal financing does not bring informational differences into play,
and to avoid initiating or increasing dividends if they anticipate that
the firm will need internally generated funds for future investments. However,
managers will avoid cutting dividends to finance new investment opportunities
because investors generally interpret dividend cuts as a signal of adverse
business developments. When managers need to resort to external financing,
they will try to issue the safest security they can to finance new investments,
beginning with safe debt (which involves fewer informational asymmetries
than equity) and then proceeding to higher risk debt, convertible debt
or preferred stock, and selling equity, which involves the greatest informational
asymmetries, as a last resort. See id. at 91-93.

The pecking order theory
illustrates how informational asymmetries may affect managers’ financing
decisions. It also is consistent with many corporations’ financing decisions,
but it fails to explain other patterns of corporate financial behavior.
That may be because the theory assumes managers always act in shareholders’
best interest but a good deal of theory and real world evidence suggests
they do not. (Recall the discussion of agency cost in Chapter 2.)
This has given rise to the agency cost theory of corporate finance, propounded
most vigorously by Professor Michael Jensen. Jensen set forth his views
at the end of the 1980s, a decade in which many public corporations became
the targets of hostile takeovers financed by high-yield debt and many others,
perhaps to fend off takeover bids, adopted highly leveraged capital structures.
He directed his critique primarily at public corporations “in industries
where long-term growth is slow, where internally generated funds outstrip
the opportunities to invest them profitably, or where downsizing is the
most productive long-term strategy.”